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The principles of portfolio diversification and asset allocation do not apply merely to broad asset categories such as stocks and bonds. They also apply to subsets of the equity universe such as sectors. The potential can be seen in the correlation between returns recorded by the S&P 500 Composite and the returns recorded by each sector sub-index in the overall benchmark. To cite one example, the industrials sub-index has correlation to the composite of 0.90, while the consumer staples sub-index has a significantly lower correlation of 0.65. What’s more, those two sub-indexes have an even lower correlation between themselves of 0.59.1

In many investors’ portfolio allocation strategies, a general allocation to diversified equity implies that the portfolio will have a weight in each sector that mirrors the sector’s weight in the overall market. But as previously noted, the sectors themselves are not precisely synchronized with each other. This suggests that each sector could have a different effect on portfolio performance each month, and that each potential combination of sector weights would behave differently. Thus, it is theoretically possible to change the performance characteristics of a portfolio by changing sector weights even if the overall weight of equity in the portfolio is unchanged.

Using sectors’ performance variations—Sector rotation

Sector rotation is the general term for portfolio strategies that vary their sector weights according to some kind of predetermined schedule. Some strategies rely on the calendar. Others follow specific economic or financial market signals, alone or in combination. Overall, there are too many strategy variants to catalogue in any single article. However, the sector-rotation concept can be illustrated using seasonal performance patterns noted by Standard & Poor’s Chief Investment Strategist Sam Stovall, who documented how historical stock market performance has tended to be stronger in winter and weaker in summer, and that while many sectors have tended to behave similarly to the overall market trend, some sectors’ performances have followed differing cycles.2

The accompanying graph illustrates a possible effect of exploiting those observations. It shows the index returns of a typical market-weighted portfolio compared with the index returns of a portfolio that follows a seasonal rotation strategy of adding exposure to the five historically optimal cyclical sectors each winter and reallocating to the two historically optimal defensive sectors each summer. The market-mirroring S&P 500 portfolio could have produced an annualized total return of 8.55% for the indicated period, based on the performance of the index. This seasonal rotation strategy could have produced an annualized return of 9.93% over the same period, based on the performance of the index combined with its relevant sub-indexes. Observed return volatility was virtually the same for both portfolios (a standard deviation of 0.43), so the seasonal rotation strategy also could have outperformed on a risk-adjusted basis.1

Growth potential of a $10,000 investment from 1990 to 2012

This chart compares the performance of two hypothetical investment portfolios using actual market index results from January 1990 to December 2012. The S&P 500 portfolio (blue line) was assumed to have mirrored the performance of the S&P 500 Composite Index over the period. The Seasonal Rotation portfolio (red line) was assumed to have mirrored a hypothetical sector rotation strategy that puts extra weight on different sectors at different times of year. The actual rotation strategy in the example was derived from Sam Stovall’s observation that the consumer discretionary, financials, industrials, information technology, and materials sector sub-indexes of the S&P 500 tend to perform more strongly than other sector sub-indexes during the November to April period each year and that the health care and consumer staples sub-indexes tend to outperform others during the May to October period.2 Using the S&P 500 Composite and its sector sub-indexes, the hypothetical seasonal rotation portfolio assumes rebalancing twice yearly to the policy allocation. It begins each November-April period weighted 80% in the composite and 4% in each of the potentially outperforming sectors for that period. It begins each May-October period weighted 80% in the composite and 10% in each of the potentially outperforming sectors for that period.1

Sector variation can also play a role in fixed asset allocation and active asset allocation strategies. In the former, a portfolio may be given a sector bias in order to alter its risk-reward profile relative to the overall market, often using calculations performed by a specialized portfolio optimization system. In the latter, investors alter their sector allocations as needed to reflect their changing views of the economy or the business prospects for a particular industry. In both of these cases, the permutations of strategy and execution are virtually limitless.

Tools for implementing a sector investing strategy

Both mutual funds and exchange-traded funds offer potential tools for obtaining concentrated exposure to any particular investment sector. Whichever product type you may favor, you should be sure that the fund you select is designed to track the sector as your strategy defines it. One way to achieve this is to seek funds that intend to reflect the performance of the same sector index you use in your portfolio planning. Also, check the fund’s tracking error—the statistical measure of how closely it follows its index target—in the fund prospectus. Finally, if you choose an actively managed fund, verify that the manager is maintaining style consistency with your specific sector objectives.

Risk and cost considerations

Active sector allocation policies tend to generate greater portfolio turnover than purely buy-and-hold investment strategies. That more frequent turnover, in turn, can increase the transaction costs incurred in managing the portfolio. Moreover, repeated trading in securities held for less than one year could make any realized capital gains short term. As a result, such gains would be treated as ordinary income for tax purposes. Gains on securities that are bought and held for longer periods could be taxed at more favorable long-term gains rates.

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One way to invest with the business cycle and diversify an equity portfolio is using sector-based securities and funds. In order to employ this type of strategy, you should know how sectors and industries are comprised.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

Because of their narrow focus, investments in one sector tend to be more volatile than investments that diversify across many sectors and companies.

Past performance is no guarantee of future results.

Diversification/Asset Allocation does not ensure a profit or guarantee against loss.

1.Source: Standard & Poor’s. The S&P 500 Composite and its sector sub-indexes are unmanaged benchmarks intended to represent potential stock market performance. While the S&P 500 has been maintained continuously since 1957, the sector sub-indexes have been tabulated in their current forms only since January 1990. Correlation, return, and volatility statistics for all illustrations in this article were calculated from monthly total returns recorded from January 1990 to December 2012. Investors cannot invest directly in any index. Index performance does not reflect the performance of any actual investment and does not take account of the fees, expenses, and taxes that are incurred in actual investments. Past performance does not assure future results.